1 - 7, 2010

Corporate governance of banks is closely linked with the corporate governance of client firms. Corporate banking provides a buffer to the two distinctly different styles of governance where corporate and banking sectors meet to make financial decisions that cumulatively promote the health and well-being of two different sectors. Well managed profitable corporate firms get a higher ranking on the banks' loan and investment portfolios.

Corporate finance is the most important area of corporate banking. The banks see corporate finance as an investment decision that promises profit maximization on one hand and keeps bank's financial risks within manageable limits on the other. Jointly, it's a structured arrangement to utilize bank's money by the corporate business in such a manner that safeguards the interest of both organizations.

Working capital finance is the trickiest part of corporate finance. A prudent and seasoned banker does not only ensure bank's safety through adequate collateralization but also keeps an eye on borrower company's business operations and borrowing policies. A failed business hurts both borrowers and lenders. Most of the businesses are known to have gone into liquidation through overtrading that essentially ensues from poor working capital management.

The use of traditional yardstick of 3Cs by the bankers demands close surveillance of borrower company's 'capacity' - one of the 3Cs. Capacity includes borrower company's ability to borrow a certain amount and to use it in the best interest of the company and in such a manner that ensures timely repayment of the debt.

State Bank of Pakistan, under its prudential regulations regime, has prescribed certain ratio benchmarks. The requirement of a certain current ratio is an attempt at keeping the company solvent on short term basis. The banks are supposed - and they certainly in most of the cases do - to keep track of company's operations through study of their periodic financial accounts. These accounts are usually published with half yearly or quarterly rests and the borrower company is under an obligation to provide these reports to the lending bank as and when these reports are ready.

Although the SBP benchmark ratios are quite useful for ascertaining company's short term and long term solvency, a really prudent corporate banker would like to see much beyond these ratios. The general rule being that short term liabilities should be financed through short term assets; the working capital finance that is normally allowed by banks for a period of one year has to deal with the current assets and current liabilities section of the balance sheet of borrower company - a general size up of other factors namely company's total assets, sales, profitability, etc. notwithstanding.

Working capital is generally measured as the sum total of all current assets. Net working capital is the difference between total current assets and total current liabilities. When total current liabilities exceed total current assets, the company is said to have a negative working capital. Inventories and receivables, being the most important segment of current assets, are generally used by the companies to avail working capital finance facility. The banks apply certain margins on the valuation of these assets so that the amount of finance is well below the present valuation of assets. The extent of margin could either be set arbitrarily or applied according to the SBP directive, in case of certain items like cotton, sugar, cement etc.

Working capital finance is usually collateralized through hypothecation or pledge of business inventories. Under hypothecation, a bank lien is created on stocks of raw material, semi-finished and finished goods, while the actual possession of inventories remains with the corporate firm. Under pledge, the actual possession of inventories is passed on to the bank that controls the inflow and outflow of raw material and finished goods. From banks' viewpoint, finance against pledge of inventories is more desirable as it affords the banks greater control over company's affairs which in turn ensures timely repayment of finance. This type of finance has its limitations too. It's less efficient and also entails pledge management costs. For each and every inflow and outflow of stocks, calculations have to be made that determine the drawing power of the company that is the extent to which the company's cheques are to be honored by the bank under the said pledge facility.

In case of full utilization of the facility, any further inventory outflows will have to be backed up by cash payments into company's pledge facility account.

The arrangement under hypothecation is referred to as running finance, while the arrangement under pledge is known as cash finance. Running finance under hypothecation arrangement where possession of inventories remains with the company is more efficient and desirable from borrower company's viewpoint. To avail such type of facility, the company has to insure all of its inventories with an insurance company of bank's choice and get the insurance policy assigned in favor of the lending bank. The company is under an obligation to provide monthly inventory reports to the bank and allow the bank inspection of inventories as and when demanded.

Working capital finance under hypothecation is obviously more risky for the banks, yet it is the most commonly utilized form of corporate finance. The market standing of a particular business group and its repayment track record determines how the banks will respond to its working capital needs. Normally working capital finances are rolled over for an indefinite period of time depending upon bank's past experience with the company.

Receivables could also be used by the companies and accepted by the banks as collateral for working finance facility. The receivables either could be simply hypothecated or assigned in favor of the bank in which case, the bank may ask company debtors to make all payments into an escrow account that is jointly operated by the company and the bank.

While liquidity ratios - current and acid test ratios - well above the SBP prescribed benchmarks are generally seen favorably by the banks, a deep analysis of company's balance sheet is what a farsighted corporate banker would like to indulge in. For example, a current assets to current liabilities ratio of 2:1 might well reveal piled-up inventories and mounting receivables which is certainly a risky business proposition that might have ensued from overtrading.